Agricultural speculation helps limit risks

Forward contracts on soft commodities are very important for the agricultural market. They help farmers, food manufacturers and dealers avoid price risks and plan responsibly. They also bring more liquidity into the markets. Speculators such as index funds play an important role in this process.

Farmers and food producers have been using futures contracts for decades to insure against price risk. Originally, most participants bought and sold physical products. Today, almost any investor can participate in the agricultural futures market – thanks to financial products like agricultural index funds.

How the agricultural futures market works

Farmers and food producers need to base their calculations on prices that are as solid as possible. This is why they enter into contracts on the futures market. Future contracts guarantee a fixed price for a fixed amount of agricultural product (e.g., wheat) on the date of delivery or acceptance. The contract only takes effect on the date agreed in the future. So when the contract is signed, the farmer (seller) does not need to have the wheat yet, and the buyer (food producer) does not need to have the required liquidity yet.

Of course, sellers and buyers have different goals. Farmers want the highest possible fixed price for their next harvest, so they need a contract partner who expects prices to rise; food producers want the lowest possible fixed price, so they look for a partner who expects prices to fall.

This is where speculators come in. Depending on their assessment, speculators bet on either rising or falling prices. This makes them the ideal partner for farmers and food companies looking to insure against their risk on the futures market.

Agricultural futures market

Agricultural futures markets help to limit risks

Future contracts guarantee a fixed price for a fixed amount of agricultural product.

A corn farmer secures the price for his next harvest on the futures market

In April, corn farmer A makes plans to sell next November’s harvest to wholesaler B at the spot price that will apply in November. He is looking for a price of 100. At the end of June, the indicators predict very good corn crops in Germany and Europe. So A worries that the prices might fall.

A insures his risk by agreeing a fixed price for his November harvest on the futures market (contract 1). His contract partner is speculator C, an index fund. C is acting as an agent: he is not interested in taking delivery of the corn; he is simply betting on rising prices, and is prepared to accept the risk that this implies.

In November, A sells his harvest to wholesaler B as planned. Shortly beforehand, he signs a second future contract (contract 2). Under contract 2, he agrees to buy the same amount of corn on the same day he sells his own corn under contract 1 – only this time at the spot price instead of a fixed price. So the content of contract 2 neutralises that of contract 1.

Let’s assume that under contract 1, A agreed to a price of 100 with C. If the spot price on the commodity market drops to 70, A will have a surplus of 30 as a result of his two contracts. He sells his actual corn to B for 70.

But if the spot price climbs unexpectedly to 120, A will have a deficit of 20 as a result of his two contracts, while B buys his actual corn for 120.

The bottom line: in both cases, A gets the desired price of 100 for his corn harvest.

So in a futures market, the only things that change hands are financial demands. The aim is to secure a desired price by spreading the price risk across several actors, using forward contracts. As a result, the obligations to sell and buy balance each other out. Professor Ingo Pies, Business Ethics expert at Halle-Wittenberg University, confirms this: “As a rule, contract parties in futures markets only exchange financial demands. “ In other words, no grain is involved.

Read more by Prof. Pies in „The Morality of Agricultural Speculation“. The full article is available in the section “Public opinions“ (in German).

The role of index funds

Index funds are created and managed by banks and insurance companies. Agricultural index funds invest in futures contracts with multiple soft commodities (e.g., corn, wheat or soy beans) that are listed in an index. Contrary to popular conception, index funds only buy futures contracts – not physical products.

Index funds then invest in corn, wheat or soybeans (given this particular example) to the same extent that these products figure on the index. So if corn accounts for 20% of the index, 20% of the investment value applies to futures contracts for corn.

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